A Primer on Private Investments
First, of course, the legal
disclaimer
Please note that the
information in this article is not to be used as consulting, accounting, or
legal advice. The following information is provided with the understanding that
this article is not a substitute for professional advice, and is merely for
informational purposes. BizPlanDB.com is not responsible for the use of any
information contained below or for the factual accuracy of any statements made
below.
The Article
Private investments are the
most exciting, secretive, and lucrative investments in the finance world. The
high premiums (usually a one million dollar minimum investment) and complicated
strategies make private investment partnerships extremely exclusive. If you
follow investment news then you may have come across headlines telling about
hedge funds, private equity, or venture capital firms. These funds are designed
for wealthy individuals and companies. There are many restrictions on who can
invest in these products so only those with unspeakable wealth have access to
the very best managers in this field. This chapter will deviate from our current
discourse in strategy and will focus on the higher echelon of finance. I feel
that having an understanding of how financial companies operate will provide you
with a more clear understanding of the finance world.
Hedge funds are the fastest
growing segment of the financial services industry. Many experts estimate that
over $800 billion dollars are invested in alternative assets. The term hedge
fund can often be misleading. Sometimes, the use of the term ‘hedge fund’ is
simply making reference to a private investment partnership that invests in
marketable securities. A true hedge refers to a defensive position created by a
money manager so that the risks associated with an investment are decreased.
Much of this text has explained several ways that risk can be reduced in the
stock market, and many hedge fund managers employ the techniques that you have
seen in order to make a profit. However, some managers exploit the private
partnership vehicle so that they can take risks not usually allowed by mutual
funds or other registered investment firms.
A traditional hedge fund is an
unregistered private investment vehicle. A minority of these funds are
registered with the Securities and Exchange Commission. Unregulated partnerships
are not illegal. Regulation D of the SEC code allows investment companies to
operate outside of the normal provisions that usually apply to securities
investment firms. Only accredited and certain non-accredited investors may
invest in hedge funds. At the time of this writing, a person must have a net
worth of over one million dollars or an income greater than two hundred thousand
dollars per year in order to be eligible for private investment partnerships.
Very few hedge funds cater to the ‘low-end’ of high net worth individuals. The
average hedge fund investment minimum is one million dollars. A hedge fund may
accept a certain number of people that do not meet these requirements assuming
that they are deemed “sophisticated investors.” The ‘sophistication’ requirement
is somewhat vague, but it usually applies to people that work in higher levels
of finance and have an understanding of complicated investments, but do not
necessarily meet the requirements to be considered an accredited investor.
Hedge funds often have access
to higher amounts of leverage. Earlier in the text we discussed the nature of
professional trading, and hedge funds often use many of the tactics described in
the second chapter in order to have access to both leverage and lower
commissions. Some hedge funds register as brokerage firms (also known as
broker-dealers) so that they can employ some of their strategies with higher
leverage. Strategies such as delta hedging demand that large amounts of leverage
be used in order to make the strategy economically feasible.
Private investment partnerships
have been around for quite sometime, but it was not until Alfred W. Jones
created the first hedge fund in 1949. His investment strategy was to short sell
overvalued companies, and purchase undervalued ones. The performance of his
funds was well beyond the average market return. In the late 1960’s, his
investment programs came to prominence, and the term “hedge fund” was coined.
Private equity and venture capital investment funds are other examples of SEC exempt investment businesses. These funds use the same provisions granted to hedge funds in order to escape the long, expensive, and frustrating process of registering securities. Large private investment vehicles are owned by insurance companies, banks, wealthy individuals, and charitable foundations. Companies that deal with financial services are automatically considered to be accredited investors. Venture capital became a buzz word in the late 1990’s as the dot com era came to peak. These funds invest in the very early stages of businesses in the hope that they will become very large and profitable companies. Generally, a venture capital fund seeks to have one to two great successes, four or five average businesses, and three to four business failures. It is a very difficult and cutthroat business. It is also extremely risky. Their counterpart is the private equity firm. These funds invest in mature companies that seek to expand. Unlike venture capital firms, private equity is a much lower risk investment. The businesses that private equity firms deal with have proven track records and product lines. Other examples of private investments involve leveraged buyouts (LBO) and real estate. The corporate raiders of the 1980’s used leveraged buyout firms to take over public companies. The practices involved with LBO’s have changed significantly over the past decade and a half. Often, LBO firms were granted nine to one leverage for a typical deal. Today, only half of the leverage that was once available may be used. Real estate funds pool large amounts of funds to use as down payments on apartment complexes, commercial real estate, etc.
Private equity and merchant banking firms almost act in the same capacity as a
commercial bank. Instead of granting a loan to a company, a private equity firm
will invest equity capital. The returns demanded by these firms are extremely
high, and so companies that have excellent growth prospects are only accepted
for investment by private equity and merchant banking investors.
Unlike hedge funds, many
venture capital and private equity firms do not accept the capital they raise in
bulk. The investors that they solicit are asked to commit a certain amount of
capital over a period of time. This is to ensure that the rate of return
achieved on their investor’s money is sufficiently high. This also allows
investors to hold other investments while they wait for a “capital call.”
Often, comparisons are made
between mutual funds and hedge funds. However, these two investment vehicles are
only similar in the sense that they both invest in marketable securities. The
largest difference between the two funds is the fees associated with hedge funds
are drastically different from their mutual fund counterparts. A mutual fund
will typically charge between .5%-2% of assets per year as their management fee.
On the other hand, a hedge fund usually charges 1% of assets and 20% of all
trading profits. The potential for creating enormous wealth draws many of the
better investment minds toward hedge funds. Redemption of shares in a hedge fund
differs from that of a mutual fund as well. Typically, there is a lock-up period
for a hedge fund where as a mutual fund has no lock up period and can be
redeemed for cash at any time. Liquidity is a large concern among hedge fund
investors, and some of these funds offer credit services so that money can be
withdrawn from a partner’s capital account at anytime.
Hedge funds are allowed to
operate in a much broader scope than mutual funds. Higher amounts of leverage
and short selling are common practices in hedge funds, but mutual funds are
bound by much tighter restraints. The SEC carefully monitors all of the
investments made by mutual funds. Minimum amounts of leverage may be used by a
mutual fund. Public investment funds also tend to invest for a longer period of
time than hedge funds. Hedge fund managers sometimes hold positions very briefly
in order to make quicker profits. The SEC exemption allows these managers to use
exotic and complicated strategies.
The way that these two entities
raise capital is also very different. A mutual fund may publicly announce the
sale of investment securities using any form of medium. If you have flipped
through an investment periodical then I am certain that you have seen
advertisements for mutual funds. These ads typically showcase the past returns
of the fund, and they provide contact information. Most mutual funds may also
solicit funds on an on-going basis. Their initial public offering never ceases
to expire, and they may accept an unlimited amount of money for investment.
Hedge funds are not allowed to advertise publicly. The restraints that hedge
funds have for raising capital are tremendous. A new hedge fund many only issue
an offering memorandum to clients that already are associated with the managing
firm, or to people that the firm knows are accredited investors (banks,
insurance companies, trusts, etc).
Limited partnerships are the
most common form of business entity that is used by hedge funds and private
equity firms. Under this agreement, the general partner (the manager) takes a 1%
ownership of the fund and sells the remaining 99% to other investors. The
operating agreement of the limited partnership allows the fund manager to
receive 20% of the profits on a quarterly or yearly basis (occasionally
monthly). The incentive fee varies by fund, and some managers may take a much
larger percentage. I have seen instances where the manager receives half of the
profits produced, although these occurrences are rare. Mutual funds are
registered as regular corporations with a tax status that allows profits to flow
directly to the investor. Unlike other regular corporations, mutual fund profits
are passed through to the investor without double taxation. Limited partner
interests are only taxed on the investor level and not on the corporate level.
When determining if a hedge fund is an appropriate investment, it is important
to understand the tax consequences. There is a distinct difference between
ordinary income and passive income, and a tax specialist should be consulted
before purchasing restricted securities. Additionally, the limited partner
structure provides limited liability for the investors. This is an extremely
important component to hedge funds because managers that use short selling and
leverage take an unlimited risk in doing so. In the event that the manager’s
positions fail, the investor’s loss is only limited to the amount of money that
they invested. This can create a problem because the manager may take excessive
risks that a prudent investor would not normally assume.
Hedge fund managers operate in many different ways. Some funds take a macroeconomic look at an economy and make investments based on predictions of the performance of the economy. Long/short equity funds take positions in undervalued and overvalued securities and attempt to make a profit on both the downside and upside of the market. Arbitrage funds practice several types of arbitrage. Other funds capitalize on one time events like mergers and acquisitions.
Unlike mutual funds, hedge fund
managers generally have a sizeable portion of their net worth invested in the
fund. Mutual fund managers tend to not invest their own money in their funds.
There is a general rule of thumb that a hedge fund manager should “eat their own
cooking.” If you are making investments in alternative vehicles, it is important
to know what percentage of the manager’s net worth is invested in the fund or
related funds. The higher the percentage of net worth invested, the more
confident an investor feels about the prospective fund.
A relatively new product in the
private investment world is the fund of funds. Instead of investing in just one
type of strategy, a fund of funds manager selects several managers to trade in
different styles. The minimum investment amount for these funds is dramatically
lower than their single strategy relatives. In some instances, a $25,000 minimum
may be the key to investing with hedge funds. However, the fees associated with
funds of funds are extremely high. You will be charged fees from the fund of
funds manager in addition to the fees from the limited partnerships. It is very
difficult to make a large profit from these investments because of the fees
levied on your returns. In the event that the fund does not post a positive
return, you will still be charged at least 2-3% of the net asset value per year.
Publicly available mutual funds are beginning to act in the fund of funds
capacity so that the average investor can have access to a once forbidden
investment. Again, the fees on these mutual funds can be enormous so it is
important to carefully inspect any prospective investment’s fee structure. There
may also be a lock-out period on these investments where you are not allowed to
remove your money from the fund for a specified period of time.
Today, there are over 6000 known hedge funds. Several hundred new private investment partnerships are formed every year. There is a high turn over rate among hedge funds as their limited partnerships do not run in perpetuity. Limited partnership investments tend to have a lifespan of seven to ten years. After the investment period is over, all of the proceeds are returned to the investors.
The business media has focused
a lot of attention on hedge funds. The funds and their respective fund managers
are often shrouded in secrecy. Very few fund managers enjoy popularity. Some of
the more well known investors include George Soros, Victor Neiderhoffer, and
Julian Robertson. The minimum investment in their respective funds tends to run
into the tens of millions of dollars. The media has also focused on the
disasters within the hedge fund community. Several hedge funds have imploded as
a result of extreme risk taking combined with the use of heavy margin. These
funds often have access to leverage outside of the standard 50% borrowing limit,
and so the potential for financial disaster is always looming. Long Term Capital
Management became an international financial spectacle with its catastrophic
collapse in 1998. This hedge fund was run by one of the most prominent Salmon
Brother’s bond traders John Meriwether. Additionally, Fisher Black (from the
Black-Scholes model) was on the board of LCTM’s management team. This fund took
highly leveraged speculative risks, and when the Russian debt crisis occurred
the hedge fund was left bankrupt. It is suspected that the fund controlled over
1.25 trillion dollars of financial instruments. In addition, they borrowed a
tremendous amount of gold in an attempt to sell short the gold market. Experts
believe that over 400 tons of gold were borrowed from money center banks. Many
broker-dealers did not require LCTM to put up the required margin for these
transactions. Under certain conditions, a brokerage firm or investment bank may
lend the hedge fund money in excess of federal requirements. LCTM often placed
no equity in their trades thus exposing the brokerages to several financial
risks. The collapse of LCTM prompted the Federal Reserve to bail out the fund.
At the time it was believed that the fund meltdown could have serious worldwide
financial consequences. This move was criticized because it created the illusion
that a hedge fund could take very large speculative positions, and in the event
that there is a problem, the Fed would bail then out.
The hedge fund world is
constantly undergoing several changes. Currently, the SEC is determining whether
or not hedge fund managers should register their investment companies. In all
likelihood there will be some form of regulation in the future. As the assets in
hedge fund near one trillion dollars, there is the concern that these private
investments could wield too much financial power. The LCTM debacle has prompted
several debates on the financial power that hedge funds control. The leverage
and ability of these fund managers allows them to have a much greater control
over markets, and thus some regulation is certainly needed.
When a hedge fund company acts
with fiduciary responsibility, the funds can be an excellent alternative
investment vehicle. If you decide that you would like to invest in a hedge fund
then it is important to make sure that you understand the fee structure of the
fund. If you are not an accredited investor then the choices you will have for
hedge fund investing will be severely limited. In these instances, the funds
available to you will most likely charge fees that are not congruous to the
performance of the fund manager. Fund of funds for the non-accredited investor
are very expensive. Better fund managers tend to cater directly to their
clients, and so the fund of funds structure may have a difficult time gaining
access to top level investment talent. It is very possible to emulate a lot of
the strategies offered by hedge fund managers. Many of the strategies that have
presented thus far are commonly used tactics. The only field that you may not
have access to in a retail brokerage account is the foreign currency exchange.
The currency markets are extremely complex, and they are not similar at all to
their equity exchange counterparts. Currency trading is also a very volatile
market. In order to be successful in currency trading, you must take a
macroeconomic look at the world’s economy. Only trained economists are qualified
to make correct assumptions about the overall economy, and it is my
recommendation that you avoid currency trading. However, if you have the
resources to work directly with talented investment managers then it certainly
is in your best interest to do so.
Investment banks act as an
intermediary and service provider for all of these players in the finance world.
For hedge funds, the investment bank provides invaluable research, execution,
and financing so that returns can be enhanced without having to accept a higher
capital risk. The job of the investment bank is to raise capital, provide
advice, perform IPO’s, and assist with trading operations for companies within
every sector of the business world. In short, investment banks bring companies
and investors together so that investments can be made. However, there is a
great distinction between an investment bank and a commercial bank. A commercial
bank accepts deposits and makes loans using those deposits. If you need a credit
card, car loan, or mortgage loan then you would go to your local branch of your
bank and apply for these financial products. Investment banks do not solicit
deposits nor are they allowed to accept them. In rare instances they will invest
their own capital in a project, but this is usually very unlikely. On the other
hand, merchant banks act in the same capacity as the investment bank, but they
use their own capital to finance investment projects. The law has changed
significantly over the last ten years concerning the governance of investment
banking. It used to be that a commercial bank was forbidden from engaging in
investment banking activity because regulators feared that depositors’ money
would be used for risky investment projects and not risk-averse loans. Since the
law has changed, almost every large commercial bank has developed an investment
banking arm.
Most people associate the work
of an investment bank with initial public offerings. When a company decides to
raise money by selling shares of a company, an investment bank is used to
underwrite and sell the issue. These financial institutions reap enormous fees
for their work, and so the competition among banks is very high. In a typical
IPO, the underwriting investment bank purchases all of the shares that a company
offers at a deep discount. This is the fee taken by the investment bank for
bringing the new shares to market. There are many ways that the banker’s fee is
calculated, but the industry standard is to receive seven percent of the total
offering. You can now see why there is much competition among investment bankers
for deals. In other dealings, such as merger and acquisition advisories, fees
are calculated on a different basis, but the revenue generated for the banks is
just as lucrative.
The investment banking industry
has come under scrutiny amid the corporate scandals over the last few years. In
this instance, the investment bankers were pressuring stock analysts to raise
their opinion about certain issues so that those companies would continue to use
that investment bank for its corporate finance projects. Unfortunately, those
who purchase shares that are rated with a biased opinion suffer. Conflicts of
interests exist because it is the investment banks objective to sell a new issue
of shares as quickly as possible. They do not like having their capital tied up
for extended periods of time. Stockbrokers that work for these firms have
pressured their clients to buy shares of a newly public company because they
receive large commissions for each sale despite the risks involved with buying
IPO shares. I do not recommend that you purchase shares of a newly public
company because the risks seem to always outweigh the benefits. Very little
information is usually available for a new issue of shares, and nor is there a
past stock performance to gauge past results against possible future outcomes.
Recent changes to the law seeks
to prevent more conflict of interest scandals like we saw earlier in this
decade, but all advice and opinions given by professionals should always be take
with a grain of salt. People in the finance industry seek to gain wealth just
like the rest of us, and on occasion people engage in illegal activity to
further their own personal agendas. Salaries and bonuses paid to investment
bankers are calculated on their work over the past year, which creates an
incentive for bankers to do as many deals as possible. In the investment banking
industry, a good investment banker can easily make a seven figure salary. In
some instances, salaries have reached into the tens of millions of dollars per
year. The majority of these bankers are extremely well educated and ambitious,
and the atmosphere among bankers is usually clouted with arrogance. Bankers work
ungodly hours. It is not uncommon for a financier to work over 100 hours per
week during a busy period.
The investment banking business is a very interesting but guarded world.
The inner workings of most investment banks are only known by a small clique of
managers that run the operations. These institutions are privy to information
that is not generally released to the public; a certain shroud of secrecy is
often one of the more prominent attributes of investment banks today.
These institutions create a
great impact on our daily lives. They organize and arrange the finance for the
companies that produce the goods and services that we enjoy. Additionally, they
help to lower the overall cost of new products by constantly financing competing
businesses. I’m sure that you can recall when a new computer cost well over
$3,000. The reason that you can purchase one for a lot less money now is because
investment bankers have financed the competition. The same applies to the
telecommunications industry. It used to be that you would pay over a dollar per
minute for your cell phone usage. Now, cell phone minutes cost just a few cents
during peak hours and at night cell phone usage is almost always free.
Investment banking firms also act as a way for investors to weed out bad
investments. The most established banks have a reputation that tells investors
that these firms have searched, analyzed, and decided which investments are
suitable and so ideas and companies that do not have a real chance of becoming
profitable never waste an investor’s money in the first place.
Financial institutions, for the
most part, simply act as intermediaries between people that have capital to
invest and people that need capital to make purchases. Commercial banks accept
deposits and make loans, and investment banks bring together equity money and
equity investments.